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Published byTimothy Reilly Modified over 2 years ago

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AD-AS Short Run Building the short run AD-AS model from the IS-LM framework

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Theory of Short Run Fluctuations Keynesian Cross Money Market IS Curve LM Curve IS-LM Model AS Curve AD Curve AD-AS Model Short-run Fluctuations Explanation The IS curve is generated from the Keynesian Cross and the LM curve is generated from the market for real money balances. Now we will generate the AD curve from IS-LM and use short run and long run models of AS to explain short run economic fluctuations.

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Fiscal Policy and the IS curve (government expenditure) Y LM Y1Y1 r1r1 r IS 1 An increase in government purchases shifts the IS curve to the right. IS 2 r2r2 Y2Y2 …which raises income... The IS curve shifts to the right by ΔG/(1-MPC),......and the interest rate.

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Fiscal Policy and the IS curve (government expenditure) Y LM Y1Y1 r1r1 r IS 1 A decrease in taxes shifts the IS curve to the right. IS 2 r2r2 Y2Y2 …which raises income... The IS curve shifts to the right by ΔTxMPC/(1–MPC),......and the interest rate.

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Fiscal Policy and the IS curve (tax changes) Note that government expenditure has a larger effect than does the same change in taxes.

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Monetary Policy and the LM curve Y LM 1 Y1Y1 r1r1 r IS 1 An increase in the money supply shifts the LM curve to the right,... LM 2 r2r2 Y2Y2 …which raises income......and lowers the interest rate.

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Monetary and Fiscal Policy Interactions Y LM 1 r IS 2 IS 1 …if the money supply is held constant, the LM curve stays the same. How the economy responds to a tax increase depends on the response of the money supply. The interest rate and output fall.

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Monetary and Fiscal Policy Interactions Y LM 1 r IS 2 IS 1 LM 2 …if to hold the interest rate constant, the money supply contracts. Only output falls. How the economy responds to a tax increase depends on the response of the money supply.

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Monetary and Fiscal Policy Interactions Y LM 1 r IS 2 LM 2 IS 1 …if to hold income constant, the money supply expands. Only the interest rate falls. How the economy responds to a tax increase depends on the response of the money supply.

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IS-LM as a theory of Aggregate Demand We now allow price level to vary in the IS- LM model. This provides a theory for the position and slope of the AD curve. Y LM(P 1 ) Y1Y1 r IS 1 LM(P 2 ) Y2Y2 Y Y1Y1 AD Y2Y2 P A higher price level P shifts the LM curve upward… …lowering income Y. P2P2 P1P1 The AD curve summarizes the relationship between P and Y.

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IS-LM as a theory of Aggregate Demand If we hold price constant we can see the effects of monetary and fiscal policy on AD via IS-LM. Y LM(P 1 ) Y1Y1 r IS 1 LM(P 1 ) Y2Y2 Y Y2Y2 AD 1 Y1Y1 P A monetary expansion shifts the LM curve outward… …increasing income Y. P1P1 Increasing AD at any given price level. AD 2

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IS-LM as a theory of Aggregate Demand Y LM(P 1 ) Y1Y1 r IS 1 IS 2 Y2Y2 Y Y2Y2 AD 1 Y1Y1 P A fiscal expansion shifts the IS curve outward… …increasing income Y. P1P1 Increasing AD at any given price level. AD 2

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IS-LM and AD-AS the Short Run and the Long Run Now lets add short-run and long-run AS to our IS-LM and AD models. Assume the economy is operating below full employment output. Y LM(P 2 ) r IS LM(P 1 ) Y AD 1 P In the short run price is fixed at P 1 and equilibrium is at point 1. As price falls money demand decreases and the LM curve shifts out. P1P1 SRAS 1 LRAS SRAS 2 P2P2 Long run equilibrium is achieved at point 2. In the long run price falls to P 2, quantity demanded increases, and equilibrium moves to point 2. This is characterized by a shifting SRAS curve.

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The Algebra of the IS-LM theory of AD The algebra behind the system is a bit tedious. But, by solving the LM curve for r and plugging into the IS curve which contains r on the right hand side you obtain the IS-LM equilibrium condition or AD curve.

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The Algebra of the IS-LM theory of AD The IS curve boils down to… The LM curve boils down to… Plugging r into the IS curve and solving for Y yields…

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Conclusions In this section we derived the AD curve via the IS- LM equilibrium condition. We looked at fiscal and monetary policy effects on the IS-LM model. We looked at the shifting effects that monetary and fiscal policies have on the AD curve and used the IS-LM model with the AD-AS model to explain short run and long run changes to the economy.

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